A tax reform deal could give a meaningful boost to the US economy and the Dollar but the devil is in the details. Details are expected Wednesday.
The US Dollar is resurgent Monday as the greenback benefits from a cloud of uncertainty hanging over European politics once again, tax reforms are put back on the table in Washington and strategists tip further gains for the currency toward year end.
Weekend reports of a possible tax reform proposal around mid-week have given a new lease of life to the Dollar bounce that began last week when the Federal Reserve indicated it will stay the current course toward higher rates.
“The market is pricing exceptionally little for US fiscal and Federal Reserve policy next year and relative US - global inflation surprises are at negative extremes,” says George Saravelos, co-head of fx research at Deutsche Bank. “We like buying the dollar against a selective basket of G10 currencies.”
When combined with possible safe haven demand stemming from the outcome of Sunday’s German election, and an already steep discount carried by the Dollar, the greenback might have the ingredients it needs to sustain an upward move over the near term.
“Persistent disappointment since the start of the year has led the market to completely price out tax reform and an unfunded fiscal stimulus in the US,” says Saravelos. “While completing tax reform may not be feasible over Q4, it is the vote on a 2018 budget with reconciliation instructions that needs to happen this year and could provide the key catalyst for a repricing.”
The call from Saravelos is notable given his team are major Dollar bears when it comes to the medium term, see here for details, given an anticipated rotation of American institutional investors back into Eurozone assets and the possibility that central bank reserves managers may also follow suit.
Saravelos reiterated his medium-term negative Dollar view on Monday and his anticipation of a Dollar bounce is purely a short term view.
“We like buying an equally weighted basket against EUR, JPY and AUD as a tactical trade. Our EUR/USD forecast for year-end remains unchanged at 1.17 but we would not be surprised if the euro correction is deeper over the quarter,” Saravelos advocates.
The Dollar has been the worst performing G10 currency during the 2017 year to date.
But The Devil Is Truly In The Detail!
The durability of any Dollar bounce on tax reforms will depend on the detail given an ongoing debate over the debt ceiling and a range of other factors.
“Congressional leaders in the US are set to unveil more details on proposed tax reforms this week, though leaked reports suggest investors have good reason to remain sceptic over US reflation prospects,” says Viraj Patel, a foreign exchange strategist at ING Group.
Notably, and almost perversely, for the US economy to see meaningful reflation and a lasting boots from tax reform, the cuts need to be unfunded.
This means the Trump administration cannot simply cut tax rates and then cut back on government spending elsewhere in order to fund the reforms as this amounts to “robbing Peter to pay Paul” and the impact for the US economy will be largely neutral.
“We take the line that tax reforms have to make both political and economic sense for markets to seriously reprice US reflation prospects; the lack of credible details on how lower taxes will be paid for means that we are not expecting any change in the current sceptic tone within markets over a Trump tax package,” says Patel.
The Dollar has fallen by 9.2% against the beleaguered Pound during the 2017 year to date, despite unease over the trajectory of Brexit negotiations and signs of a slowdown in the economy.
But Optimism Remains And Don’t Forget; Repatriation!
Last week the Senate Budget Committee agreed to allow a $1.5 trillion extension to the budget deficit over the next ten years, which could provide for an unfunded tax cut to some extent.
This is while the recent cross-party agreement between President Donald Trump and leaders of the Democrat party has pushed the debt ceiling debate into the long grass of December, with a hard deadline for another agreement not coming until March next year.
“There is huge incentive alignment for Republicans to deliver on tax ahead of the mid-terms and the debt ceiling deadline has been pushed out to after March 2018 anyway,” says Saravelos.
In addition to agreeing personal and corporate tax cuts, a key item on the Trump administration’s tax agenda is a separate rule designed to incentivise the repatriation of American companies’ foreign profits.
US companies hold as much as $2.6 trillion of cash offshore, all foreign profits, in order to protect themselves from the hefty 35% corporate tax rate levied on American companies’ earnings.
“Even if most offshore earnings are held in dollars we estimate there are $100-150bn of profits in foreign currency. The indirect effects of repatriation may be larger,” says Saravelos.